Weil Restructuring

In Pari Delicto — An Auditor’s Best Friend?

Contributed by Andrea Saavedra
The fallout from the failures of Refco, Madoff, MF Global, and many other investment firms in the past decade has spawned numerous lawsuits against, among others, the firms’ advisors by trustees and customers seeking to recover losses resulting from a broker’s alleged misappropriation of customer securities and cash.  As courts continue to sift through the specific facts and circumstances of these cases, one rule — the New York common law doctrine of in pari delicto — has been consistently applied to dismiss claims brought by a failed firm (or its successor in interest, such as a bankruptcy trustee) against its auditors.  A recent decision by Judge Marrero of the United States District Court for the Southern District of New York in MF Global’s customer class action litigation proceedings reaffirms the doctrine’s strength in these types of cases.
In previous blog entries, we’ve discussed in pari delicto, which generally stands for the proposition that courts will not interject themselves into disputes between two wrongdoers and is rooted in the public policy purpose of deterring illegality by denying judicial relief to an admitted wrongdoer.  The doctrine has been applied to limit the standing of bankruptcy debtors or their trustees to seek recovery from third parties — such as auditors — alleged to have joined with, or aided and abetted, the debtor in fraud.  Because a corporation can only act through its agents, the fraudulent acts of the corporation’s agents are imputed to the corporate debtor, and, as a result, the corporation or someone charged with the duty of pursuing the debtor’s or customers’ claims — such as a bankruptcy trustee or trustee appointed pursuant to the Securities Investor Protection Act (SIPA) — lacks standing to recover from such third parties.
The facts underpinning the MF Global decision stem from the firm’s infamous failure in October 2011.  The lengthy complaint filed by MF Global’s former customers paints a picture of desperation at the firm in the summer of 2011.  The plaintiffs allege that, facing severe liquidity constraints, MF Global’s directors and officers chose to test the limits of legality by shoring up various entities within the MF Global enterprise with the customers’ assets.  As liquidity tightened, management allegedly authorized the transfer of more and more cash until there was a nearly $1.6 billion hole in customer accounts at the time of its bankruptcy filing.  As a consequence, customers initiated class actions to recover their lost funds, all of which were consolidated before Judge Marrero.  The customer-plaintiffs are also pursuing claims of MF Global that were assigned to them by its SIPA trustee.
In the MF Global decision, the court was asked to consider dismissal of claims against (i) certain of the firm’s former officers and directors and (ii) its outside independent auditor.  The court determined that, with certain exceptions, the claims against MF Global’s former directors and officers — for aiding and abetting MF Global’s violations of certain regulatory requirements regarding customer asset segregation; aiding and abetting MF Global’s violations of its fiduciary obligations to customers; conversion of customer assets; aiding and abetting conversion; negligence to customers; and tortious interference with contract or business advantage — would not be dismissed.  Although in pari delicto was not relevant to its analysis, the court did find, among other things, that MF Global, and not the director and officer defendants, had direct fiduciary, regulatory, and contractual obligations to its customers.  Therefore, only those claims that were either derivative or otherwise properly directly asserted against the directors and officer defendants survived.
Turning to the customers’ claims against MF Global’s auditor, the court found that, despite their reliance upon its independent audit as a check on the firm’s internal controls and procedures, a “failure of [the] regulatory structure” did not give rise to the customers’ claim for professional negligence.  Absent contractual privity, their claim was barred as a matter of law.  As to the trustee’s assigned claims, the court similarly ruled in the auditor’s favor, finding that, under the principles of in pari delicto, the auditor could not be held liable for either professional negligence or breach of fiduciary duty to MF Global.  The court observed that, with respect to auditors, the policy principle underlying in pari delicto — preventing the “creditors and shareholders of the company that employs miscreant agents to enjoy the benefit of their misconduct without suffering the harm”  — applied with particular force.  As the customers’ were pursuing the claims of MF Global’s trustee, they were, in essence, standing in the shoes of MF Global.  Because the complaint alleged that MF Global, through its management, had engaged in some unlawful, even if not fraudulent, activity, it, as the plaintiff, and the auditor, as defendant, both had “dirty hands.”  Therefore, neither could pursue claims against the other on account of damages emanating from their mutual course of conduct.  In addition, the court found that there was no equitable rationale to favor the “innocent” customers over the “innocent shareholders” of the auditing firm.  Rather, it explained, the doctrine of in pari delicto focuses on the “relative fault” of the parties involved to prevent a windfall to either wrongdoer.
Accordingly, all claims against the auditor were dismissed, and the court expressed its displeasure with the plaintiffs for bringing these claims as they flew “in the face of clear precedent” from the Second Circuit Court of Appeals and the New York Court of Appeals on the issue of in pari delicto.  In other words, (duped) auditors (and other duped advisors) take note — you have a friend in in pari delicto.

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